Chapter 3( Demand theory and analysis) PDF

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Chapter 3 (Demand theory and analysis) Individual demand: In determining what to purchase, individual consumers face a constrained optimization problem. That is given their income (the constraint), they select that combination of goods and services that maximizes their personal satisfaction. These choices involve a comparison of the satisfaction associated with having a good or services & its opportunity cost. In a market economy opportunity cost are reflected by prices. Thus, prices act as signals to guide consumer decisions. A high price denotes a significant opportunity cost while a lower price indicates that less must be given up. Law of demand : There is an inverse relationship between price and quantity demanded- as price increases, quantity demanded will decrease. The law of demand can be explained in terms of substitution and income effects resulting from price changes.

Why there is an inverse relationship between price and quantity demanded in the law of demand? It is because of substitution and income effect resulting from price changes.

Substitution effect: When the price of goods increases, its opportunity cost in terms of other goods also increases. Consequently, consumers may substitute other goods for the good that has become more expensive. Example: Income effect: When the price of a good increases, the consumer’s purchasing power is reduced and he buys less than before. Thus, the price increase is equivalent to a reduction in the consumer’s income. Example: Market demand: The market demand for a good or services is the sum of all individuals demands. It is aggregate demand or summation of individual demands. Example: let a market that consists of only two buyers(A and B).The demand curves for both consumers are shown in the figure. These demand curves show the relationship between price

and quantity demanded .The consumer A’s demand curve is shown in the first panel (D 1D1) and that of consumer B in the second panel (D 2D2).At a price of $10 the individual quantities demanded are 5 and 8 units respectively. Hence total market demand (DMDM) is 13 units.

Price per unit($)

Price per unit($)

D2

D1 15 15 10

D2

10 D1

2 4

8

5 Quantity per period

Quantity per period

Price per unit($)

DM

15

10 DM

6

13

Quantity per period

Fig:The market demand curve

Determinants of market demand: 1.Price of good

3. Income

2.Consumer preferences

4. Prices of other goods

If there is change in price of goods then the movement of quantity demanded will be along the demand curve. But if there is change in consumer preference, income and prices of other goods then there will be a shift in demand curve.

To understand determinants of demand we need to understand 2 concepts. These are: 1) Change in quantity demand 2)Change in demand Change in quantity demand: A movement along the demand curve in response to a change in the price of a good or service is referred to as a change in quantity demanded. Change in demand: In plotting a demand curve it is assumed that other factors that affect demand are held constant. When these factors are allowed to vary, the demand curve will shift. Such shifts are referred to as changes in demand. A shift to the right is called an increase in demand, meaning that consumers demand more of the good or service at each price than they did before. A leftward shift indicates a decrease in demand. That is less is demanded at each price than before.

Prices of other goods: The demand for a good is often influenced by changes in the prices of other goods. Other goods include substitutes and complements. Substitutes are goods that have essentially the same use. When the price of a good goes up, the demand for its substitutes is likely to increase. Example: Sprite and &-7-Up. (Substitutes) Tennis racket and tennis balls (Complements)

F Price (Increase) = Quantity demanded for substitutes (Increase) [Pos relation] Priceof(Increase)= Quantity Prices sprite increases

demanded for complements (decrease) [Neg relation]

Price per unit($) D’ D

D’ D

Quantity of 7-Up per period

Interpretation:7 -Up and sprite are similar lemon-flavored soft drinks. As increase in the price of sprite would cause people to buy less of that beverage and consume more 7 up. Thus, the demand curve for 7 up would shift to the right from DD to D’D’. For compliments Prices per unit($) D’ D

D

Quantity of tennis balls

D’

Interpretation: An increase in the price of one goods will cause the demand for its compliments to decrease. If the price of rackets increases fewer people will play tennis. With fewer people involved in the sport, fewer tennis balls will be purchased. This outcome is illustrated by the leftward shift of the demand curve from DD to D’D’. The market demand equation:The market demand function can also be expressed mathematically as follows QD = f(P,I,P0,T) Here, P=the price of good or service P0 = the prices of other goods T= measure of consumer tastes and preferences This equation implies only that there are general relationships.it says nothing about there nature and magnitude. Quantifying this information requires that a functional form be chosen to represent the equation for market demand. The linear form is below: QD =β+ apP+ aII + a0P0 + aTT The coefficients a indicate the change in quantity demanded of one unit changes in the associated variables. For example, QD=50+2P+1.5I+1.2P0+0.5T Interpretation: For price change of 1 unit the change in quantity demanded will be 2 units. For the change in 1 unit in income the quantity demanded will be 1.5.For the price changes og other goods by 1 unit the quantity demanded will be 1.2. Let income(I),P0, P and T are constant. Then there will be no effect on quantity demanded. In that case QD=β+apP Here, B=combined influence of all the other determinants of demand and ap≤0. (neg sign) Negative sign of ap indicates there exist inverse relation between price of good and the quantity demanded.

Price elasticity: A price change can either increase or decrease total revenue depending on the nature of the demand function.so managers need a method of measuring the probable effect of price changes on the total revenue.one such measure is price elasticity of demand.it is defined as the percentage change in quantity demanded divided by the percentage change in price. Ep=

%∆Q %∆P

Where Ep = price elasticity of demand Let , Ep=-3%/2% =-1.5 (Ep is always neg) Interpretation: when price rises by 1% quantity demanded will fall by 1.5 percent Point versus Arc elasticity: there are 2 approaches to compute price elasticity. These are point elasticity and arc elasticity. Arc elasticity: It is appropriate for analyzing the effect of discrete or measurable changes in price.

A

P1 Price

B P2

Q1

Q2

Quantity

Here , AB=segment of a curve ∆ P=P 1− P 2=measurablechanges ∈price

Ep=

%∆Q %∆P

=

∆ Q / Q ∆Q P × = ∆ P/P ∆ P Q

Therefore, Ep =

Q 2−Q 1 (P2+ P 1)/2 × P 2− P 1 (Q 1+Q 2)/2

Ep Q

Q

P

P

Let , when price is $6 quantity demanded is 5 units .when price rises to $10 quantity demanded falls to 1 unit Ep=

1−5 10 + 6 × =−2.67 10−6 1+ 5

Interpretation: When price rises by 1% quantity demanded will fall by 2.67%.similarly if price falls by 1% quantity demanded will increase by 2.67%.

Point elasticity: it is used to evaluate the effect of very small price changes or to compute the price elasticity at a particular price. It is used in theoretically. Ep=

dQ P × dP Q

where

dQ =first derivative dP

P/Q= initial price and initial quantity

1)Ep >1 (elastic demand) [%∆ in quantity demanded >%∆in price] 2)Ep 0 an increase in the price of y causes an increase in the quantity demanded of x and the two products are said to be substitutes eg chicken and mutton are substitutes.an increase in the price of chicken increases the demand for mutton. Cross elasticity of complements If EC...